Proposed Regulations on Interest Expense Deduction Limitation – The Real Estate Provisions
On November 26, 2018 the IRS issued proposed regulations on the new business interest expense deduction limitation under IRC Sec. 163(j), as modified by the Tax Cuts and Jobs Act (the “TCJA”).
The TCJA created a new set of rules limiting business interest deductions in 2018 and thereafter. These rules are expected to greatly impact taxpayers with outstanding debt obligations. Many of these taxpayers were able to deduct all of their interest expenses paid or incurred during the taxable year, subject to certain exceptions or restrictions. The TCJA puts a cap on many of these deductions. This may particularly affect real estate entities which are highly leveraged, as debt financing may become more expensive for such businesses subject to the limitation. There are, however, some important exceptions and planning considerations for businesses under the TCJA. This alert focuses specifically on the provisions of the TCJA as they relate to real estate entities.
‘New’ Section 163(j)
In general, under “new” IRC Sec. 163(j), the amount of business interest allowed as a deduction for any taxable year shall not exceed the sum of:
- The taxpayer’s business interest income for the tax year;
- 30% of the taxpayer’s “adjusted taxable income” for the tax year (this amount cannot be less than zero); plus
- The taxpayer’s floor plan financing interest for the tax year.
The business interest limitation applies at the taxpayer level.
The amount of any business interest not allowed as a deduction for any taxable year under the general limitations above is treated as business interest paid or accrued in the succeeding taxable year and may be carried forward indefinitely, subject to certain restrictions applicable to partnerships.
There are two important exceptions from which real estate entities can benefit:
- Small Business Exception
The business interest limitation does not apply to a taxpayer that meets the $25 million gross receipts test of IRC Sec. 448(c) for any tax year. Under this test, average annual gross receipts may not exceed $25 million for the prior three-taxable-year period. Aggregation rules apply in calculating the $25 million gross receipts test.
The proposed regulations clarify that the gross receipts test of IRC Sec. 448(c) is an annual determination based on the prior three taxable years and that a taxpayer’s status as an exempt small business under IRC Sec. 163(j) may change from year to year. In a year in which the taxpayer’s status changes to an exempt small business, the taxpayer may deduct the entire amount of previously disallowed interest carried over into the year plus the full amount of the current interest expense unless the deduction is disallowed, deferred, or capitalized under another provision of the Code.
- Electing Real Property Trade or Business
For purposes of the business interest limitation, certain types of businesses are not considered a “trade or business” and are therefore exempt.
One of such businesses is an “electing real property trade or business” which is any trade or business that:
- Is described in IRC Sec. 469(c)(7)(C) (real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business), or certain trades or businesses that are conducted by real estate investment trusts (“REITs”) and
- Makes an election under IRC Sec. 163(j)(7)(B). The election must be made at the time and in the manner prescribed by the IRS.
The election is available to any taxpayer involved in such a real property trade or business, including corporations and REITs. However, this election comes at a cost. Once this election is made, it is irrevocable, and making the election requires the electing business to use the alternative depreciation system (“ADS”) to depreciate any non-residential real property, residential real property, and qualified improvement property rather than the general modified accelerated cost recovery system (“MACRS”) of IRC Sec. 168. For nonresidential buildings the ADS life is 40 years (as opposed to MACRS of 39 years) and for residential property it is 30 years (as opposed to MACRS of 27.5 years). The ADS for qualified improvement property is currently 40 years (as opposed to MACRS of 39 years). However, this appears to be a congressional oversight and it is anticipated that the ADS for qualified improvement property will change to 20 years and that MACRS will change to 15 years. Additionally, any electing real property trade or business is not eligible to use the new 100% expensing rules of the TCJA. The TCJA implemented 100% expensing for certain business assets placed in service after September 27, 2017 through December 31, 2022 in place of the current 50% bonus depreciation for qualified assets. The amount of bonus expensing allowed will decline by 20% each year until it phases out completely for qualified property placed in service after December 31, 2026. In some cases, the significant cost of taking less depreciation pursuant to this election may not be worth the additional interest expense deduction. Therefore, a cost-benefit analysis needs to be made prior to making this election.
The proposed regulations added the following additional rules relating to the electing real property trade or business election:
- Proposed Reg. Sec. 1.163(j)-9 provides the procedure that will be used to make an election to be treated as an electing real property trade or business. It clarifies that the election is made for a particular trade or business, not necessarily for a particular entity; it would apply for the taxable year the election is made and all subsequent years.
- Proposed Reg. Sec. 1.163(j)-9(g) provides a safe harbor for certain REITs. If a REIT holds real property, interests in partnerships holding real property, or shares in other REITs holding real property, the safe harbor provides that the REIT is eligible to make an election to be an electing real property trade or business for all or part of its assets. The term “real property trade or business” in IRC Sec. 469(c)(7)(C) does not include real property financing and, for purposes of the IRC Sec. 163(j) regulations, any assets used in a real property financing trade or business are generally allocated to a non-excepted trade or business. Under proposed Reg. Sec. 1.163(j)-9(g), REIT real property financing assets include interests (including participation interests) in mortgages; deeds of trust; installment land contracts; mortgage pass-thru certificates guaranteed by GNMA, FNMA and the Federal Home Loan Mortgage Corporation; real estate mortgage investment conduit (REMIC) regular interests; certain other interests in investment trusts and debt instruments issued by publicly offered REITs. If a REIT makes an election to be an electing real property trade or business, and the value of the REIT’s real property financing assets at the close of the taxable year is 10% or less of the value of the REIT’s total assets, then, under the safe harbor, all of the assets of the REIT are treated as real property trade or business assets. If a REIT makes an election to be an electing real property trade or business, and the value of a REIT’s real property financing assets at the close of the taxable year is more than 10% of the value of the REIT’s total assets, then, under the safe harbor, the REIT’s business interest income, business interest expense, and other items of expense and gross income are allocated between excepted and non-excepted trades or businesses (under rules set forth in proposed Reg. Sec. 1.163(j)-10, as modified by proposed Reg. Sec. 1.163(j)- 9(g)(4)).
- Proposed Reg. Sec. 1.163(j)-9(h) provides that if at least 80% of a trade or business’s real property (by fair market value) is leased to a trade or business under common control with the real property trade or business, the trade or business cannot make an election to be an electing real property trade or business. This was added to prevent taxpayers from restructuring their businesses such that the real estate components of non-real estate businesses are separated from the rest of their business to artificially reduce the application of IRC Sec. 163(j) by leasing the real property to the taxpayer and electing this “business” to be an excepted real property trade or business.
The new rules are complicated and may result in more costly debt financing. This may be aggravated if interest rates rise. Businesses may need to reevaluate their debt structure and work closely with their tax advisors to plan accordingly.